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Criteria for Evaluating Budget Plans

May 4, 2012

On Wednesday I visited the University of Chicago, where I made a presentation on "The Challenge of Stabilizing Federal Debt" and spoke with a number of professors. My hosts included several members of CBO's Panel of Economic Advisers, and I was pleased to be able to spend time with them and with other members of the Chicago faculty.

I'm often asked to comment on the merits of various plans for reducing budget deficits relative to those that will occur if we continue current tax and spending policies. Of course, CBO does not make policy recommendations. Rather, in my presentation yesterday, I discussed several criteria that might be used by policymakers and citizens to evaluate budget plans. The way that people think about these criteria, and the relative importance they attach to them, will vary according to their individual preferences and priorities.

#1: Magnitude of Policy Changes

There is no commonly agreed-upon amount of federal debt that is optimal. Higher debt has a number of negative consequences that CBO discusses regularly, but reducing debt or constraining its growth will require some combination of tax increases and spending reductions, and those policy changes can have negative consequences themselves.

Under current law, significant changes in tax and spending policies will occur by the end of the year, and with those changes, CBO projects that debt held by the public would decline gradually relative to GDP, reaching 61 percent by 2022 (still well above the average of the past several decades). But if most tax and spending policies that have recently been in effect were to remain in place (as assumed in CBO's projection labeled the "alternative fiscal scenario"), debt would rise steadily relative to the size of the economy, reaching 93 percent of GDP by 2022. That trend could not be sustained indefinitely.

Policymakers will need to make judgments about how much federal debt is acceptable. To move from the path of debt under the alternative fiscal scenario to the path of debt under current law would require a cut in deficits of about $8 trillion during the next 10 years, amounting to more than a trillion dollars per year by the end of the coming decade. To stabilize the debt as a share of GDP at its current level (about 70 percent of GDP) would require smaller but still substantial savings; to push debt as a share of GDP down toward its average of the past several decades (less than 40 percent of GDP) more rapidly would require larger savings.

#2: Specificity of the Proposals

Is a plan explicit as to how deficit reduction would be achieved? Specificity is critical not only to evaluating a plan, but also to the economic effects of the plan. Credible policy changes that would substantially reduce deficits later in the coming decade and beyond could boost the economic expansion in the next few years by holding down interest rates and increasing people's confidence in the nation's long-term economic prospects. Such an approach would be most effective if the future policy changes were sufficiently specific and widely supported that households, businesses, state and local governments, and participants in the financial markets believed that the future fiscal restraint would truly take effect.

#3: Amount and Composition of Federal Spending

Over time, the federal government will need to collect revenues roughly commensurate with its outlays. With that in mind, how large should federal outlays be? And what should the composition of those outlays be? We are on track for a budget future that looks very different from our budget past, and budget plans have an opportunity to reinforce current trends or to reverse them.

The cost of Social Security and the major federal health care programs is rising rapidly, from an average of 7.3 percent of GDP during the past 40 years to a projected 12.8 percent of GDP in 2022 under current policies. That's 5½ percent of GDP more devoted to those purposes, owing to a combination of the aging of the population, rising costs for health care per beneficiary, and expansions of federal programs. In contrast, all other federal spending apart from interest on the debt is projected to be 7.8 percent of GDP in 2022, about two-thirds of its 11.4 percent average share over the past 40 years. Under such policies, total noninterest spending is projected to be 20.6 percent of GDP in 2022, about 2 percentage points more than the average during the past 40 years. Moreover, a much larger share of that spending will be going to benefits for older Americans and a much smaller share to other types of benefits and services. Policymakers and citizens need to form their own judgments about the desirability of those shifts and the extent to which they should be modified.

(Those figures consider federal spending as traditionally recorded in the budget. Many analysts consider so-called tax expenditures-reductions in revenues arising from exclusions, deductions, exemptions, and credits in the income tax system-to be effectively federal expenditures as well. CBO wrote about those tax provisions in its latest Budget and Economic Outlook.)

#4: Short-Term Economic Impact

Policymakers face difficult trade-offs in deciding how quickly to implement policies to reduce budget deficits. On the one hand, immediate spending cuts or tax increases would represent an added drag on the weak economic expansion. In addition, implementing spending cuts or tax increases abruptly would give families, businesses, and state and local governments little time to plan and adjust. On the other hand, cutting spending or increasing taxes slowly-which would tend to boost output and employment in the next few years, compared with what would happen if those changes were made rapidly-would lead to a greater accumulation of government debt and might raise doubts about whether the longer-term deficit reductions would ultimately take effect.

Despite those trade-offs, however, I am not aware of any benefit to delaying decisions about future changes in tax and spending policies. Indeed, as I noted above, credible policy changes that put the debt on a sustainable long-term path could boost the economy in the near term.

#5: Medium- and Long-term Economic Impact

Beyond the next few years, budget plans could affect output and income by altering the size and skills of the labor force, the amount and composition of the capital stock, and the efficiency with which those inputs are combined. Smaller deficits would lead to higher national saving in the medium term and long term, and higher national saving would lead to a larger capital stock owned by U.S. citizens through a combination of higher domestic investment and lower net borrowing from abroad. Budget plans can also affect the capital stock by changing taxes on saving and investment, and they can affect the labor force by changing taxes on earnings.

#6: Distributional Consequences

The sixth criterion I discussed for evaluating budget plans was who would bear the burden of the proposed changes in tax and spending policies. Different sorts of spending cuts and tax increases would affect different people to different extents, both through the direct channel of who pays certain taxes or receives certain benefits or services, and through the indirect channel of how the changes in policies affect the economy and thereby affect people's well-being.